First there was Harrisburg, Pennsylvania. Then, Jefferson County, Alabama. Now, hold onto your hats folks -- we could be just days away from seeing the biggest municipal bankruptcy in U.S. history.

In California, the city of Stockton boasts a population of almost 300,000 ... and a fiscal emergency. The first number means that if Stockton winds up filing for Chapter 9 bankruptcy protection, as its officials are threatening to do, it will be the most populous U.S. municipality ever to declare bankruptcy. And the fiscal emergency? Such problems are going to become increasingly common as city after city follows the downward path that Harrisburg, Jefferson Co., and Stockton have blazed.

A city in decline
Eighty miles to the east of San Francisco, in the 19th century Stockton was a hub of the California gold rush. But by the end of the 20th century, a gold rush of a different sort had arrived. Amidst a nationwide housing boom, Stockton rode high on a wave of mortgage refinancings, building fees, and property tax collections. As the city's vice mayor explained, money was "pouring into the city coffers for development fees and permits. Property taxes were going through the roof. It was boom time."

Then the Great Recession hit. 

Today, Stockton sports an unemployment rate nearly twice the U.S. average, at 16%. Foreclosure rates for the city have ranked in the top 10 among U.S. municipalities for five years running. And with the money spigot now turned off, Stockton now struggles to keep up with payments on the debts it rang up during the boom.

Stockton's fiscal "budget" for this year calls for expenditures 20% greater than the revenues Stockton expects to take in. Even after planned spending cuts, next year's budget will still leave the city with a $20 million deficit. No wonder, then, that both Moody's and Standard & Poor's rate the city's debt as "junk" -- which means it's too risky for the agencies to recommend investing in it.

And yet, this problem is hardly new. For nearly a year now, city officials have been warning that Stockton was close to "insolvency." So why hasn't Stockton done anything to fix its problem?

Because they can't.

How we got here
According to Standard & Poor's, 52% of the city's budget already goes to paying the local constabulary, and another 30% more to paying firefighters. But the balance must cover everything from maintenance and street lights to paying off debts rung up during the boom:

  • A minor league baseball stadium that was originally seen as costing $20 million.
  • $22.4 million to build a marina (which was supposed to pay for itself, but actually consumes $700,000 in city subsidies annually).
  • $63 million for a new hockey arena.

Earlier this month, Stockton's City Council voted to try to avoid bankruptcy by the curious method of defaulting on $2 million in bond payments. But even that won't be enough to save the city.

Hip deep in pension obligations
The real cause of Stockton's deficit, of course, is retirement costs. Last year, banking analyst Meredith Whitney cited the rising cost of municipal pensions as a key factor that could spark "50 to 100" municipal failures, and "hundreds of billions" of dollars in municipal bond defaults across the U.S. As you can imagine, this is a big part of the problem in Stockton. When things were going well, the city council voted time and again to boost the benefits doled out to its public workforce, including:

  • automatic salary increases for city employees, whether tax revenues could support the pay hikes or not;
  • a health-care plan that guarantees lifetime benefits to every city employee (and his or her spouse) -- no matter if the employee spent only a month on the job;
  • pension benefits that have the city on the hook for nearly one hundred $100,000-per-year pensions (and counting).

Today, Stockton's unfunded pension obligations total $450 million. And, to hear City Manager Bob Deis tell it, these costs are what are really killing Stockton's budget: "Multiyear labor contracts with escalating costs ... simply cannot be paid with anticipated revenues in the foreseeable future. ... Absent some negotiated adjustments to the city's financial obligations, the city will be insolvent and will have no alternative than to seek bankruptcy protection."

"This place is about to blow..."
The 24 biggest pension plans in the U.S. are a collective $136 billion in debt, funded to a level that's barely half what they need to meet their long-term obligations. Fixing this problem will require either massive cuts in benefits that have been promised to government workers, or else equally massive tax hikes upon the working public. Or both.

If Stockton does declare bankruptcy, it may be the biggest in U.S. history -- but it won't be the last.

At the time this article was published Motley Fool contributor Rich Smith does not own shares of any companies named above. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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